Quarterly Review and Outlook – 2nd Quarter 2018

I’ll gladly pay you Tuesday for a hamburger today

 Investors encountered a mixed bag during the second quarter of 2018. US large cap equities were slightly up: the S&P 500 gained 3.4 percent, and the Dow Industrials added 1.2 percent. It was the riskier issues that gained the most, with the NASDAQ up 6.6 percent for the quarter and the small cap Russell 2000 sailing 7.7 percent higher. Buoyed by a spurt of tax-cut fueled earnings growth, domestic investors alternately freaked out and then chilled in the face of perils posed by trade policy errors and threats of escalation.

 Frustratingly (for value managers), the divergence between soaring growth stocks and value laggards continued to widen. Students of the markets will recall that such imbalances eventually equilibrate, reverting first back to the mean, and then typically overshooting it. Votaries of value investing find such times of imbalance replete with opportunity, but acknowledge the need for longanimity while the rest of the world rediscovers these tenets (too slowly for our taste).

Meanwhile, for fans of foreign markets which had been stalwarts during the previous year, the ride was somewhat bumpier than for US stocks. The MSCI EAFE index of developed international stocks dropped about 1 percent, and the emerging market benchmark fell 7.8 percent. No great tax cuts over there to offset rising trade tensions and a plethora of geopolitical risks including a disorderly Brexit process, intensifying concern over China’s debt, and renewed solvency worries in Europe, this time courtesy of the Italians.

Back in the good old USA, the stock market climbed a wall of worry (don’t you hate that overused cliché?) and focused on what can only be described as a robust economy. The benefits from the tax cuts will nearly all be exhausted by year-end, while the reckoning for such profligacy will extend over at least a generation. But for now, enjoy the party. Or to paraphrase J. Wellington Wimpy, let’s chow down today and settle up later.

US economic growth surged to a 4-year high during the quarter ending June 30. The nation’s output of goods and services grew at an annualized rate of 4.1 percent, according to the first estimate released last week by the Bureau of Economic Analysis. The Bureau also revised first quarter growth upward to 2.2 percent. This indisputably strong report stoked optimism over the prospect of continued vigor through the end of the year.

Digging a bit deeper, it is possible to point to several factors that may prove to be somewhat more transitory. Tax cuts and exports figured prominently, but likely cannot be counted on to repeat their performances over a longer stretch.

GDP or Gross Domestic Product is the government’s best measure of economic activity, and represents the sum total of all goods production and service delivery in the US, a monumental $20.4 trillion. We compute the growth in GDP from one quarter to the next to gauge the strength and momentum of the economy, and provide important information for investors and policymakers. This makes it important to explore the nuances in the data that lie below the surface.

 By far the biggest contributor to GDP is consumption spending by individuals and households, representing 68 percent of the total. Consumers opened up their wallets in the second quarter, most likely driven by an increase in disposable income from the tax cut bill. Workers are seeing the full impact of personal tax rate reductions in their paychecks, and while small, the difference is tangible. Furthermore, many large companies announced one-time bonuses of $1,000 to $2,000 as the result of the corporate tax cuts at the center of the bill. These infusions are not likely to be repeated, but showed up at the mall and the grocery store.

In the end, about two thirds of the gain in GDP was attributable to the 4 percent increase in consumer spending. Maintaining this rate of growth is likely to prove challenging.

The second-biggest contributor to the boffo report was an unlikely suspect: exports. US exports surged in the quarter, contributing about one-fourth of the increase in GDP. Much of this unexpected strength appears to have been preemptive action by American farmers, and soybean growers especially, to ship out as much product as possible before threatened tariffs were formally imposed. According to estimates from Morgan Stanley, soybean shipments increased by 9,400 percent in anticipation of Chinese retaliatory tariffs. Most likely, trade will again become a drag on growth in the next period.

Government spending, the third of the four components of GDP, increased in the second quarter thanks to a budget-busting appropriations bill adopted by Congress and signed by the President on March 23. The boost in government expenditures was responsible for 9 percent of the bump in output. This considerable hike in Uncle Sam’s purchases will be paid for by…wait for it…increasing the national debt.

The fourth constituent of national output is private investment. An improvement in new spending for capital goods and structures was offset by a sharp drawdown in business inventories to put a slight damper on the overall growth figure, but the impact was negligible.

By any measure this was an excellent report, and continues to provide evidence that the US economy is humming along nicely. But quarter-to-quarter growth numbers tend to be highly volatile and quite noisy. Economists expect full-year growth around 3 percent this year and mid-2s for 2019, as the potency of the panchreston known as tax reform wanes, while surging deficits and trade threats impede forward progress. Still, it sure feels good to see a 4-handle for a change.

In addition to what proved to be a bang-up quarter for growth, stocks also caught a more direct tailwind fanned by the vaunted tax cut bill enacted in December. The corporate tax rate reductions were ostensibly expected to clear the way for a flood of domestic capital investment that would improve productivity and stimulate job creation. Additionally, proponents argued that a significant slice of the newly enlarged profit pie would be served up to workers in the form of higher wages.

 As it has turned out, relatively little has found its way to the dinner table. According to a detailed survey analysis by not-for-profit ranking firm Just Capital, only 7 percent of the bonanza has gone to workers, and just 18 percent into investment. Unsurprisingly, the lion’s share has been redirected to shareholders. Fully 57 percent of the tax bonus has would up in stock buybacks and dividend payments (exactly as most economists had predicted).

Meanwhile, tax cuts will add at least $1 trillion to the debt, while the March budget resolution and appropriations bill exemplified the very quiddity of fiscal malfeasance. New projections from the CBO now expect the 2019 deficit to be double the original projection for the 2018 shortfall. And if that weren’t enough, Congress and the President are discussing a plan to make the temporary elements of the tax cut permanent, catapulting the projected debt to two times the entire size of the US economy by 2048. In 2041, Social Security, health care and interest on the debt will exceed all federal revenue. Interest alone will become the single largest item in the budget.

 One of the explicit justifications for the tax cut bill was the prospect of higher wages. It was this promise that essentially allowed a measure so overtly weighted toward wealthier taxpayers to gain acceptance of middle-class wage earners. As the chart below documents, this has not happened. In fact, despite growing evidence of labor shortages, average wages have been falling since the tax cut passed. It is eminently plausible that voters will lose their patience and enact their own version of reform during the midterm elections.

Markets in the US have responded favorably if not effusively to the impressive growth in the economy during the second quarter. But due to the temporary nature of the stimulus, mounting pressure of deficits and simmering voter dissatisfaction, risks are growing. Better enjoy that hamburger. Would you like fries with that?

Christopher A. Hopkins, CFA

© 2018 Barnett & Company


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